A changing market landscape

AEGIC’s recent reports on Russia and Ukraine show their emergence as major players in the global wheat market, forcing a rebalancing of global supply and demand for wheat. One thing is clear - we are likely to see particularly fierce head to head competition between North America and the Black Sea producers in the Asian market for feed grains.

With Russia to the left of us and the USA to the right, there is the risk we become the figurative meat in an unpalatable sandwich, where we must compete on price with countries who can produce wheat more cheaply than we can, due to either lower input costs, cheaper supply chains or economies of scale. As an example, Russia has the stated goal of increasing wheat production by more than 23 Mmt over the next decade or so, which is around the total usual size of Australia’s wheat crop. Unless we suddenly breed a new wheat variety that thrives in redundant iron ore mines, it is difficult to see where large swathes of virgin cropland are laying idle, ready to come online. And this is just Russia. In addition, we face a similar situation (albeit on a smaller scale per country) with Ukraine, Argentina and Eastern Europe.

While feed grain markets are undoubtedly massive, the wheat supplied to these markets tends to be undifferentiated to the point of fungibility. By this I mean that a tonne of feed wheat from one origin is viewed by buyers as being substitutable with a tonne of feed wheat from another origin half way around the world. In this sense, these commodities are equivalent to the bottom tier of low cost supermarket private labels, which are also viewed as mostly interchangeable.

As I mentioned in my piece on branding (available here), you should always choose the battlefield where you have the best prospects for success. A few decades ago, a new entrant into the US market for headache tablets wanted to take on the dominant player – Tylenol (the US equivalent to Panadol). They did this by pricing their product at a discount to Tylenol, hoping to attract price-conscious customers away from the well-known segment leader. Suffice to say, this was a bad strategy. The dominant player usually enjoys considerable scale benefits due to the higher volumes they sell, and thus have a lower break-even point. In fact, segment leaders will even tolerate selling below their cost of production for a period of time as a way of killing off competition. And this is exactly what Tylenol’s massive owner, Johnson & Johnson, did to this hapless hopeful.

The Australian wheat industry needs to ensure it chooses its battlefields carefully, as some of our competition is blessed with either more (arable) land, more fertile land, or a combination of the two.

In my experience, when companies have a near death experience or some other moment of existential crisis where there are no immediately obvious paths to recovery, they often do one of two things when the traditional sources of capital (primarily, issuance of shares or secured lending) dry up – they either offload their only profitable businesses for quick cash to keep the Armani-clad wolves from the door, or they begin a disorderly process of selling trading stock at below market value to generate cash-flow. However, in most cases, both options are no better than shuffling deck chairs to get a better view of the iceberg. While no-one ever wants to admit it, these options set in motion a chain of events that almost always signpost the beginning of the end. The equivalent scenario for the Australian grains industry would be to try to cut costs by pulling away from grains R&D, investment in premium-paying markets and the provision of technical extension for these markets. Similarly, there is a risk that we look around at the competition and conclude that we should hitch our wagon to the same “high volume, low cost” locomotive that appears to be hauling Black Sea competitors out of a long post-Soviet malaise and into our key export markets.

On the rare occasion someone is foolhardy enough to ask for my input on a new business venture, I always ask the same first question – What is your edge? In other words, what do you have that your competition doesn’t? If we were to head down the path of “yield, volume, price”, ultimately, what would be our point of difference? In recent years we have seen the emergence of “flour additives” as a topic of critical importance. Additives to flour include a wide range of conditioners and enzymes used for a wide variety of purposes. One of these purposes is the use of non-grain additives to help grain with functional deficits “punch above its weight”. Australia may end up grabbing a lucrative share of this market through the development of additive IP (intellectual property). If we were to develop particular additives (such as enzymes) that were tailor-made for Australian wheat, this could also provide us with a powerful means to tie closely with our customers. However, on the flip side, we need to ensure we consider the chain of cause and effect far enough to get greater comfort around the question of unintended consequences. So, to play devil’s advocate, it’s not difficult to see the potential problems we would face in a market landscape where non-agricultural, industrial additives are used in place of grain quality. Why buy Australian Prime Hard (APH), when you can buy General Purpose (GP) and condition the flour? What happens when another country develops the technology that is ultimately adopted by the market? And if you condition the consumer to accept bread made with conditioners, you also condition the millers to using the cheapest source of wheat, which is likely to be countries like Russia. Hence, the potential danger is to look at potential revenue that additives may generate, offset against the drop in demand for premium grades, and then taking a position that it is just “robbing Peter to pay Paul”, when in actual fact, we are “robbing Peter to pay Vladimir”.

So, clearly, “lowest price” is not a battlefield we should focus on. This doesn’t mean that price is irrelevant. Just that price is but one part of the equation that determines something much more important – value.

Let’s illustrate further.

Black & Gold Grain

Let’s assume for a moment that my wife instructs me to pick up Coles Black & Gold® Instant Coffee. Naturally, my first reaction would be to take a long hard look at myself, questioning what earlier missteps and poor life decisions led me to the point where I would consider drinking instant coffee. However, if we suspend disbelief momentarily and assume that I would willingly comply with such an improbable request, I know that if I instead returned with Woolworths Home Brand® Coffee, it would be unlikely to elicit a complaint. With some rare exceptions, consciously or unconsciously we view these products as interchangeable. How many times do you think someone has complained “I told you I wanted a 30-roll value pack of Homebrand toilet paper, not 30 roll value pack of Black & Gold toilet paper!”?

However, if I am instructed to pick up a takeaway coffee from a branded chain but instead return with a Home Brand or Black & Gold coffee, then I may need to consider alternative living arrangements.

Is the Australian Grains Industry more suited to the strategy of high volume/low margin/low differentiation, like that of a 3rd party manufacturer of private label products, or the kind of high margin/low volume/high differentiation business typically undertaken by companies who can leverage their brand equity to charge a higher price? If you forced me to pick, I would say the latter. However, the point is that we don’t have to pick one or the other.

The likely most effective strategy will involve a mix of high value, differentiated crops/grades, supported by a base cargo of comparatively (but not totally) commoditised offerings.

Are we Lindt or Hershey’s Kiss?

There is a reasonably well-known experiment in behavioural economics conducted by Dan Ariely (Professor of Psychology & Behavioural Economics at Duke University and author of Predictably Irrational), where subjects first had a choice between paying $0.01 for lower quality chocolate (Hershey’s) and $0.26 for better quality chocolate (Lindt). Roughly half went with each option. The reason this experiment was so interesting was because of what happened next. They then repeated the experiment, however first reducing the price of each option by $0.01. Faced with a choice of $0.25 for Lindt and $0 for Hershey’s, 90% went with the Hershey’s, with the conclusion being that “free” involves a different mindset than “not free”. What does this conclusion have to do with Australian grain? Absolutely nothing. However, if we back up one step to the first part of the experiment, another aspect I have always found interesting was that the premium product was 26 times more expensive than the cheap product, yet around half were happy to pay that premium. Implicit in this choice is the fact that those who chose Lindt perceived it as better value at that price.

Value lies at the intersection of price and quality, viewed through the subjective prism of the buyer or consumer.

Computationally, we can simplify by saying that “price” and “quality” are the two key bits of data affecting decision-making. This means that if you conduct the above experiment many times, gradually widening the price spread, subjects will eventually all change to Hershey’s.

If we look at the price/quality/value story in the context of our actions, perhaps it is more helpful to think in terms of “levers” we can pull. Generally speaking, price and quality are the two main levers we have available, and of the two, quality is the lever we as an industry have the most control over. To continue the “lever” imagery, the “price lever” is at eye level, while the “quality lever” is located much further up the same wall, effectively putting it out of reach of all but a few international grain producers, including Australia. So, do we focus on the lever anyone can easily reach, or the lever that only a small number of producers (including Australia) can reach?

In actual fact, it is inaccurate to talk about a single “quality lever”, when it is more accurate to view quality as numerous smaller levers that all contribute to perceptions of “quality”. Say, we as an industry determine, via objective quantification, that our future lies in better meeting the requirements of our customers. A critical pre-requisite will then be to undertake activities that identify these levers and their relative importance, while at the same time demonstrating the economic rationale for this particular course of action. For example, identifying these levers may signpost the value of a particular variety, grade or general trait. However, when we look inwards, we may find that the only varieties available suffer from a 20% yield disadvantage compared to growers’ alternatives. I know of very few examples where the market could bear a 20% premium over the benchmark used. In this instance, yield becomes the rate-limiting step that puts the market out of reach until a suitable variety becomes available. Neither yield nor price are meaningful in absolute terms, but instead, one must be viewed through the prism of the other.

So, with the prospect of an additional 20+ Mmt of cheap, low to medium grade hard wheat supply knocking on the door of our key Asian markets,

Do we try to simply produce cheap, low to medium grade hard wheat and compete on price, or do we work to identify where the future sources of margin will be and recalibrate accordingly?

Identifying the most likely sources of future profitability for Australian grains is an activity we as an industry have no choice but to undertake if we wish to safeguard the ongoing viability of wheat exports as greater volumes of cheaper, lesser quality wheat is produced elsewhere in the world, leading to exportable surpluses that will go forth in search of demand.

The good news is that work is underway, at various levels of the grains industry (including AEGIC), aimed at addressing many of issues raised in this piece. So, the purpose of this article isn’t to catalyse action, but to hopefully provide context and rationale for the abovementioned activities, as well as introducing some questions that might be helpful topics for discussion. Indeed, these are some of the points of discussion that underpin the work our team is currently undertaking and thus will no doubt feature prominently in future blog posts.

Peter Elliott is AEGIC's Manager of Strategy & Analysis. Prior to joining AEGIC, Peter was Regional Manager - Europe and The Americas for CBH Grain. Peter began his career working for the Japanese trade house Mitsui & Co. and prior to that, he lived in Kobe, Japan.

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